New VCT rules could force collaboration with buyout funds

On 18 November the Finance Act was given royal assent, meaning changes made to VCT and EIS structures are now part of UK law. The changes have been driven by the UK's need to bring state aid rules in line with those of Europe; but they mark potentially the biggest changes witnessed since the creation of VCTs 20 years ago.

The key changes for VCT and EIS fund managers are that investments can no longer be used for buyouts, ie for the buying and selling of ownership stakes. Other important changes include limits on total amounts that can be invested: a £12m cap has been introduced for most businesses, apart from those deemed as ‘knowledge-intensive', where up to £20m can be deployed. Furthermore, restrictions have been placed on the age of eligible companies: a VCT or EIS investment must now be made within seven years after the business's first commercial sale, or up to 10 years for knowledge-intensive companies.

Side effects
As part of the European Union, the UK had little choice over implementing these changes. European state aid rules are there to promote and protect the single market and to prevent governments supporting individual organisations, which could lead to them having an unfair advantage.

However these latest changes could bring about not only some immediate challenges for the VCT industry, but could also encourage some new behaviours.

The most obvious impact is of course the limited pool of VCT and EIS eligible companies. Restrictions on the age of suitable businesses as well as the amount that can be invested will reduce the number of opportunities available. And, as these investments can no longer be structured as management buyouts, it is likely that deals in VCT pipelines may have to be scrapped, as part of the original offering would have been to enable stake sales. According to industry sources, around 60% of VCT deals will need new structures or will have to be aborted.

Another source believes the new rules could see a swathe of VCT funds falling by the wayside, with only the top performers being able to raise new funds in the future. That same source believes some kind of hybrid approach will emerge, where VCT managers operate institutional funds as well, as a means of side stepping the recent changes in order to survive.

Another, but perhaps less severe change, could be that we see more co-investments at this end of the market, mirroring wider trends in the large- and mid-cap segments. Where VCTs have deals in the pipeline that require a management buyout structure, fund managers could partner with non-VCT funds as a means of structuring the deal and get it over the line, or as a way of obtaining extra cash needed if the deal is worth more than £12m.

Loophole lapse
There are exceptions to the new rules, and one in particular seems troubling. If an investment materially changes a business – if it moves the company into a new market or sector – then VCT and EIS managers are allowed to invest after the original time limits. The amount that can be invested is restricted to 50% of the company's last three years of combined revenue. However, this is a grey area that requires HMRC approval.

This could be seen as a win for investors. But on the flipside, what if during the early stages of developing the business into a new geography or sector the plan backfires, and actually that kind of expansion is not suitable? Would it mean the business has to keep going with its original plan or will the investment have to be repaid?

Fortunately, there is some light at the end of the tunnel. While these most recent changes have now been made legal, the UK government is clearly committed to softening the rules, and bringing back elements of VCT and EIS investing that were permitted in the past - namely the ability to use this investment as replacement capital. In his autumn statement, the UK chancellor, George Osborne, said: "The government will also continue to explore options to introduce increased flexibility for replacement capital within the [VCT] schemes."

For VCT fund managers concerned about how to transact within the new framework, solutions are emerging. The first, as noted above, is to team up with alternative providers of capital – say, buyout funds – as a way of retaining deals that require a buyout structure. The other would be to invest smaller amounts as a way of bringing the target company into the portfolio and hold on until the UK government brings through changes around replacement capital under the European Risk Finance Guidelines.

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